How ExxonMobil's God Pod beat Iraq's oil chieftains at their own game.

By Ben Van HeuvelenBen Van Heuvelen is the managing editor of Iraq Oil
Report. As a freelance journalist, he has written for the Atlantic and Salon, and he blogs at benvanheuvelen.com.

October 26, 2012

In 2006, an Iraqi technocrat named Tariq Shafiq was charged with crafting an oil law. A Berkeley-trained engineer, he began his career in the 1950s, rising through the consortium of foreign firms that comprised the Iraq Petroleum Company — until the Baathists nationalized the oil sector and sentenced him to death, in 1970, for conspiring with the imperialists. Luckily, Shafiq had been out of Iraq at the time, and he didn’t return for decades. But now he would again find himself at the center of controversy.In a country that receives 95 percent of its revenue from oil, his oil law would not only shape the management and regulation of the national economy but also determine the extent to which power would be centralized in Baghdad. It was the centerpiece of Iraq’s own version of the Federalist Debates.

On the federalist side, Iraq’s minority Kurds — who had already gained significant political and military independence in their semi-autonomous northern region — argued that dispersing state power could prevent the kind of oppression that had been fueled by Saddam Hussein’s complete, unwavering control of oil revenues. It would be a safeguard against tyranny. The centralists, on the other hand, argued that a Balkanization of the oil sector would lead to conflict, with local governments fighting over cross-border oil fields; moreover, they said, it would be a bad value for Iraq. If different parts of the country were bidding to partner with the same top companies, they would inevitably undercut one another. Shafiq had suffered at the hands of oppressors in Baghdad, but he still took the centralist view.

"Without a central unified policy there will be disharmony and competition between [Baghdad] and among the various Regions and Governorates," he wrote in 2006. "This would lead to an unhealthy oil industry … contributing to the fragmentation of the country." But his prescient words were lost in Iraq’s fractured politics.

Six years later, Shafiq’s draft is languishing in a Parliament committee, and the debates over federalism still rage. On the ground, however, where both sides have signed billions of dollars’ worth of contracts, the battle has been lopsided: The federalists in Kurdistan are winning, for the simple reason that their best ally is more powerful than any of Baghdad’s. That ally is ExxonMobil.

It was not always so. For several years, Iraq’s central government was in control and Exxon was jockeying to be one of its biggest partners. In January 2010, the company agreed to invest billions of dollars in a super-giant oil field in Basra called West Qurna 1, aiming to increase output there to more than 2.8 million barrels per day by 2017 — a level roughly equal to Exxon’s current total worldwide production. "Our long-term strategic objective in Iraq is to be there for many, many years, and to be a valued partner of the government, and to be a part of the success of their society," an Exxon executive told me in 2009.

Now everything has changed.

On Oct. 18, 2011, Exxon signed six exploration contracts in Kurdistan. The move represented a seismic shift in Iraq’s balance of power: Exxon was by far the largest company to align with the Kurds, and it openly betrayed Baghdad to do so. Iraq’s top oil official, Deputy Prime Minister for Energy Hussain al-Shahristani, had warned Exxon that signing with the Kurds would be illegal, and constituted a breach of the West Qurna 1 contract. But Exxon’s lawyers disagreed. Baghdad was on weak legal footing, since — in the absence of a modern oil law to bolster its position — the Oil Ministry’s claims, of primary authority over contracting, rested on subjective interpretations of Iraqi law.

In an uncomfortable meeting with Shahristani, a senior Exxon executive explained his company’s intentions in Kurdistan. The Iraqi government had made its objections known.

"Thanks to you … Iraq’s position was very clear all along," the executive said, according to Shahristani. But they would sign with Kurdistan anyway.

Several people familiar with the company’s internal decision-making have told me there were a few simple reasons that Exxon was willing to risk its relationship with Baghdad. First, Kurdistan’s geology looked very promising. Second, the Kurdish government’s contract terms offered much greater profit potential. And third, Exxon could probably get away with it. A year later, Baghdad still has not backed up its threats to kick the company out of Basra.

Even so, Exxon is preparing to break ties with Baghdad altogether. The company is actively seeking buyers to take over West Qurna 1. Meanwhile, executives in Exxon’s headquarters in Irving, Texas — which some employees jokingly call the "God Pod" — have decided to double down on Kurdistan. In the past year, they have spent about a quarter-billion dollars to buy equipment and mobilize rigs for exploration drilling.

Other oil giants are following Exxon’s lead. France’s Total and Russia’s Gazprom both signed deals in Kurdistan over the summer, despite also holding contracts with Baghdad that are now in jeopardy. Chevron signed for two Kurdish exploration blocks in July. Unlike the others, however, Chevron had never even bothered with the central government in the first place: The company’s leaders thought Iraq was driving too hard a bargain.

Indeed, Shahristani’s terms had been tough. At the time of his first contracting auctions, in 2009, he was balancing two competing imperatives: first, he believed that only international companies could achieve the production and revenue levels needed to rebuild the country; second, in the aftermath of a humiliating occupation, he felt enormous political pressure to avoid the appearance that Iraq was being economically re-colonized by the West. He needed to let the oilmen in, and to look strong doing it.

His solution was both technical and theatrical. In late 2009, the Oil Ministry staged two televised auctions with all the trappings of a game show. In a large auditorium lined with maroon velvet chairs, Shahristani — who looks like an Arab version of Richard Dreyfus — stood on a stage as bidders walked up one by one, to insert envelopes into a clear plastic box. Those bids were evaluated according to a formula that was simple enough for the television audience at home to understand: The company promising to produce the most oil for the least money would win.

The auctions were a case study in what Exxon executives privately called "the dark side of transparency." They complained that a single, reductive number could not capture the value of a bid, particularly those aspects that would favor Exxon. Iraq ought to be asking which company would best manage the long-term health of its fields, train local staff, and bring in cutting-edge technology. Instead, it was feeding a low-bid war, creating incentives for companies to cut corners.

In the first auction, Exxon was outbid by BP for the Rumaila oil field, which is even larger than West Qurna 1. In the second auction, wary of losing another chance to win a foothold in the world’s third-largest conventional oil reserves, executives in the God Pod sucked it up and accepted Shahristani’s thin profits. According to several people familiar with the decision, it was part of a longer-term plan. Exxon’s leaders had such confidence in their company’s ability to prove its value to Iraq — executing projects on time, keeping to budgets, instilling its business practices in local staff — that they believed Baghdad would notice the difference and expand their partnership down the road, when the political climate might allow for more reasonable contracts. Establishing a stellar track record had already helped Exxon win an enormous position in Qatar’s booming gas sector. It underpinned the company’s Iraq strategy, too.

Chevron had been far more skeptical. Shortly after Exxon signed for West Qurna 1, Chevron Vice President Donald MacDonald met with Ambassador Pat Haslach, who was then a top State Department official working on Iraq, at the U.S. Embassy in Baghdad. She asked him why his company had decided not to invest.

"The structure of the bid round prevented a competitive bid," MacDonald replied, according to a diplomatic cable published by Wikileaks. The profit margins were simply too thin, especially given all that could go wrong.

Beyond the volatile political and security situation, Iraq would need billions of dollars’ worth of supporting infrastructure — new pipelines, pumping stations, storage tanks, and export terminals — to support so much new production. All of that was outside the scope of the companies’ oil field contracts, and MacDonald doubted that Iraq had the institutional capacity to execute so many large projects at once. He also doubted that Iraq would actually want to produce as much oil as its new contracts anticipated. The deals would need to be renegotiated, he said, "and I have never seen a renegotiated contract benefit an [international oil company]."

All of those worries turned out to be prescient. At West Qurna 1, for example, the original production schedule is now in shambles because Iraq is so far behind with key infrastructure. The government has also failed to make prompt payments for the output that has been achieved. As a result, the cost of financing the project has eroded Exxon’s profit margin. To cap it off, Prime Minister Nouri al-Maliki’s top oil adviser, Thamer Ghadhban, recently announced that Iraq is cutting its production ambitions by one-third — an implicit admission that its original goals were too optimistic.Such a reduction would likely hurt several companies, including Exxon, whose profits are essentially proportionate to their production increases. The contracts seem destined for renegotiation.

Kurdistan, on the other hand, has done everything it can to woo the oil companies. The regional capital of Erbil has the feel of an oil boom town, where luxury hotels are opening up one after another, and real-estate speculators are flipping cookie-cutter houses for ballooning prices. At the heart of this exuberance is Kurdistan’s minister of natural resources, Ashti Hawrami, whose development strategy has centered on oil contracts that promise generous rates of return, padded to offset the political risk that comes with the territory.

That risk is substantial. Not only does Baghdad consider the Kurdish deals illegal, but it also controls the country’s network of export pipelines. As of now, Kurdistan’s oil producers have made most of their money by selling crude at roughly half price to domestic refiners within the region. They have intermittently exported through Baghdad’s pipelines, but have only been paid for a fraction of that output. Nobody is quite sure how — or whether — the central and regional governments will create a durable enough arrangement to support the kind of large-scale exports that Exxon and Chevron will need.

For the moment, Hawrami’s promises are enough to reassure investors. He speaks of raising Kurdistan’s production capacity by a factor of 10 this decade, to more than 2 million barrels per day. On its face, the proposition is absurd: What company would spend hundreds of millions of dollars to drill for oil without a plan for how to sell it? But in the magical thinking that sometimes animates bullish capitalists, the traditional logic has been reversed.

"The scale of the opportunity for Kurdistan and for Iraq is so large that there will be a resolution," said Tony Hayward, the former CEO of BP, who is now running a small Anglo-Turkish company invested in Kurdistan called Genel Energy, in an interview with Reuters. Hayward has often contended that oil and money, if gathered in sufficient quantities, are subject to a kind of natural law of international financial osmosis: "Over the next year or two, Kurdistan production capacity will grow towards 1 million barrels a day — that’s too much oil to be shut in as a consequence of a political dispute. So one way or another, it’s going to get resolved."

Call it the Field of Dreams theory of oil dispute resolution — "if you drill it, they will come around" — yet the premise gained mainstream credibility the moment Exxon signed with Kurdistan. Initially, only no-name companies had bought Hawrami’s pitch. Now, the world’s most profitable company had gone in. With Exxon’s imprimatur, Hawrami kicked off what he triumphantly dubbed "a season of mergers and acquisitions." Total, Gazprom, and Chevron all signed deals in a span of two weeks in July.

Kurdistan’s investment bonanza stood in flattering contrast to Baghdad’s anemic attempt to attract similar enthusiasm. In May 2012, the Oil Ministry again gathered international oil executives in its auditorium for another game show-style auction. This time, Iraq was offering 12 new exploration blocks. Some of the same companies that had attended the earlier auctions were there, but many of the largest were absent.After each block was opened for bidding, a period of awkward silence ensued. The participants had 15 minutes to drop their envelopes into the clear plastic box, but two thirds of the blocks didn’t receive any bids. The silence was filled mainly by the theme song from "The Godfather," which the ministry had inexplicably chosen for the soundtrack of the proceedings. At the end of the event, they played a nationalist song called "A Victory to Baghdad," but the lyrics rang hollow.

"I believe the Iraqis have to reconsider the terms in order to attract other people," said Sara Akbar, the CEO of Kuwait Energy, in an interview with Iraq Oil Report. "For these terms, [many blocks] cannot be developed."

As the oil companies migrate north, political clout is moving with them. The British government just announced it is closing its consulate in Basra, partially to shift resources to Erbil. More importantly, Kurdistan is enjoying a renaissance in its relations with Turkey. Historically the Turkish government has been wary of supporting Kurdish autonomy in Iraq, for fear of emboldening its own Kurdish minority to expect similar levels of independence. Yet a series of regional dynamics has been pushing the two sides closer together: the civil war in Syria, Maliki’s worrisome alignment with Iran, and Turkey’s booming economy, which is ever more hungry for energy. On all three counts, the Iraqi Kurds could be valuable allies.

Against this backdrop, the Turkish government has provisionally approved the construction of oil and gas pipelines to the Kurdish border. Such infrastructure would be transformational for Iraq and the region. It would bring Kurdistan to the brink of economic self-sufficiency; that, in turn, would threaten to sever the ties of financial reliance on Baghdad that have kept Kurdistan from declaring itself an independent state.

All of this has made Maliki both angry and anxious. Kurdistan’s potential secession is only part of the problem. The larger issue is the federalist precedent that Kurdistan is setting. Other provinces have enviously noticed the Kurds’ success, and want to emulate it. Populist politicians in provincial governments around Iraq — even many whose parties are formally aligned with Maliki — have taken to advocating for greater autonomy within a loose, federal system. If such a movement were to gain traction in a key province like Basra, the source of 70 percent of Iraq’s oil production, it could undermine the power of the central government.

The push for regional autonomy has been relatively mild so far outside of Kurdistan, largely because Maliki retains so much power as the commander of the armed forces. Yet the federalist movement also reflects the fears expressed by Tariq Shafiq in 2006: Iraq is a country competing with itself to win foreign investment, haunted by the prospect that its internal conflicts will combust into violence and even war. Many of Baghdad’s critics in Kurdistan and within oil companies blame the government for being too stingy and controlling. They may be right — but those are only symptoms of a deeper political dysfunction in which the Kurds and the companies are fully complicit.

From the Kurdish point of view, of course, the picture is quite different. A long-oppressed minority group has used the competitive dynamics of global capitalism to win an unprecedented level of control over its own fate. They have leveraged the full might of the private sector. Or, as the Kurdistan region’s President Massoud Barzani once put it: "If ExxonMobil came, it would be equivalent to 10 American military divisions…. They will defend the area if their interests are there."